I do subscribe to the investment theory that the four most dangerous words to investors are “it’s different this time.” Those words were certainly used to justify the astronomical valuations of internet companies, before the bubble burst and we all learned that it wasn’t so different.
But with that caveat in mind, why is the current financial mess different from the internet bubble bursting? Simply, collapsing credit is different than collapsing equity values.
When stocks in companies like AOL plummeted from their heights, many people lost, but there was never any assumption that those who lost were owed anything. It’s simply the risk that comes from investing in equities. The value was destroyed, egos were bruised, dreams were dashed, but investors could slink away and lick their wounds in private.
When loans, default, however, those who made the loans expect to be made whole. Somebody has to pay back the losses (see posts on bank capital and why bank capital matters), unlike during the internet meltdown where nobody had to repay anything.
Where will the pain be felt? First, the Federal government through it’s obligations under the FDIC insurance program (see post on Treasury Bailout), is on the hook to make sure depositors (us ‘lenders’ who expect to be made whole, by way of our banks) don’t lose. Second, the shareholders whose capital has been wiped out in failures like Washington Mutual, have lost their entire investments. Some banks have been successful at raising additional shareholder capital, most recently JP Morgan Chase in a stock offering, but also as private investors like Warren Buffett and middle eastern sovereign wealth funds buy into banks and investment firms. Third, the borrowers who binged on cash out refinancing and debt loads they were unqualified to carry will pay some through a mix of paying underwater mortgages, paying restructured mortgages, or suffering foreclosure. Fourth, many of the the investment banks that packaged mortgages into complex derivatives have either failed or been forced into shotgun mergers by regulators, have paid.
Unlike the internet bubble burst (which was complicated further by the subsequent terrorist attack on 9/11) where the hangover simply wore off like hangovers do, this problem will take lots of hands-on restructuring of banks, mortgage and home ownership, and credit market assets. Think of this more like recovering from surgery than recovering from a hangover.
September 29th, 2008 at 8:31 am
So the big question is what will happen to the economy and the markets when an if the bailout package is passed and everyone starts to feel the pain. It seems to me we will experience a delayed inflation for starters. In other words all the money created in the last few years and chased the limited supply of real estate and other goods with little reported inflation will now see inflation catch up with prior actions. Moreover, the government seems to be filling this void of bad debt with cash created out of nowhere which also has to be highly inflationary. The good news is that outstanding loans will be paid back with money that is worth less than when it was borrowed. The bad news may be that we also enter a prolonged recession. What’s your take on the future?
September 30th, 2008 at 7:50 am
Sorry for the delayed response. Many of the things going on in the economy are deflationary–housing price declines, consumption declines due to credit and wealth effects, unemployment rising, commodity prices weakening as demand softens. I don’t think inflation is the worry right now. I am, however, worried about a prolonged recession. I don’t think we should believe that housing prices re-inflate to bubble levels, so we have to work through a long period of housing restructuring (foreclosures, bankruptcies). I also believe that the banking system is so badly undercapitalized that this will take some time to repair. Consumer sentiment surrounding the politics will also contribute to demand contraction.